Markets are absolutely focused on when the Federal Reserve will hike rates. And it seems most are expecting that this will be the start of a market correction. The reality is the exact opposite is likely to happen with the first rate hike likely to be a take off point for equity markets on a case of “sell the rumor and buy the fact”.
Why will there be a sell the rumor and buy the fact scenario with the first rate hike in the US? Well firstly a sell the rumor and buy the fact is a circumstance which occurs quite often where a stock or market experiences selling pressure and declines on the basis of expected bad news to be released. This is the rumor. When the bad news is eventually released a combination of all the selling interest having been completed already and/or the news not being as bad as expected creates a situation of virtually no more selling and it only takes a small amount of buying interest to push values higher. If buying interest is strong and aggressive, say with short covering, rallies can be very swift and sharp and at face value make utterly no sense whatsoever with the actual announcement.
So in the case of the US and its first rate hike there is a widespread view from a rate hike this year starting as early as September, with others expecting the first rate hike not to occur until well into 2016.
I believe there will be a rate hike in September or October.
The Federal Reserve is itching to conduct the first rate hike. Just to get away from zero rates. While there are dovish members on the board who believe waiting until 2016 is the best policy, the reality is that interest rate policy will be still very loose (extremely) and that the process to the normalization of interest rates will be a process of many year not many months. It will be slow and I suspect at least 5-6 months before the second rate hike occurs.
By raising rates in 2015, the Federal Reserve will be able to take advantage of market expectations. By raising rates when the market expects it most will result in arguably less volatility since the element of surprise will be at its lowest.
Currently Fed fund futures are pricing in 55% chance of a rate hike in September. This is up from 45% last week. Equity markets on the other hand are not pricing in anywhere near this level of probability. This inherently poses a risk.
If rhetoric from the Fed continues to push towards a rate hike in September or October and Fed fund futures increase the probability towards 100%, equity markets will be vulnerable to a sell off. This is the sell the rumor stage.
But following the rate hike, the Fed WILL try and calm markets down and emphasise that a second rate hike will be data dependent and will require a further acceleration in the US economy. Markets will take the first rate hike as a vote of confidence and will rally strongly from that low point. This will be no different to last October when the Fed completed its QE3 program the S&P 500 dropped sharply only to see it reverse quickly and make new record highs just weeks later.
A rate hike in June, July or August is unlikely. The data in the second quarter is not strong enough to warrant a rate hike. The second quarter bounce in US GDP will come below economists’ expectations of a 2.2% annual growth rate. The Atlanta Fed GDP tracker which correctly predicted the soft first quarter indicates GDP is tracking at a 0.8% annual rate.
A rate hike in November or December is too close to Christmas which will impact investor and consumer confidence when it seasonally is at its strongest. The Fed knows this so such action would be more likely from the RBA than the Fed.
Finally, history has shown that equity markets typically peak 6-12 months on average, following the first rate hike. This is usually the result of markets being confident that the economy is strong enough to handle rate hikes and in preparation for the first rate hike, the Fed talks up the economy and the data supports continued growth in underlying corporate profits. Typically 6-12 months later that positive momentum begins to slow and equity markets peak as rising rates begin to reduce the appeal of equity markets and if the ensuing rally is sufficiently frothy, a bubble may be there to burst.
A September rate hike would suggest markets could peak anywhere from March 2016. However, considering the rate hike cycle will be extremely slow this time, the absence of a really frothy bubble (except for unlisted tech stocks) and QE in Europe running until September 2016 equities could rally for longer than in previous cycles.
Either way, the tantrum equity markets throw when the Fed firms its rhetoric on a September/October rate hike will create a great buying opportunity and not the SELL that most commentators are suggesting. If you want to sell, do it soon because when equities do drop sharply it will be a time to BUY.
